Thoughts on Value and Growth Part 2

Just a few more thoughts on the ever-present debate between these two schools of thought within the value investing community…

The Value vs. Quality Debate

The big debate is always how much to pay for growth and how to value it. Earnings are often linked to “growth” or “quality”, while net tangible assets are usually linked to “value”. Deep value guys will say that growth can’t be predicted and so you have to buy assets cheap (rely on low valuations or low P/B ratios). But relying solely on this method means that these investors are relying on the market to eventually agree with them. Granted, this usually happens, but it still indirectly a “projection” that the market will revalue the assets at a higher multiple.

Side note: I’ve heard some fellow deep value guys scoff at other investors who use earnings multiple expansion as an input in their value calculations. I share this skepticism… but these same skeptical asset investors often assume asset multiple expansion (higher P/B ratios) when buying stocks at .7 times book.

I’m not sure either approach is philosophically much different. I personally love asset backed investments that are cheap. But I tend to prefer to invest in cheap situations where my returns are predicated on the business results more than the revaluation (earnings or asset multiple) that Mr. Market assigns to my holdings. The latter usually works out when you buy something cheap, but when it doesn’t, it’s nice to know that the business you own is more valuable now than it was when you bought it. A business that is growing its intrinsic value provides an added level of safety to the investment.

Cheapness Plus Compounding Intrinsic Value

In the 1950’s, Buffett invested in the stock of a small bank in New Jersey at a large discount to book value, but that wasn’t the only reason he bought the bank. He invested in that stock because of the combination of cheapness (a P/E of 5 and a discount to book value) and quality. Buffett mentioned that the business was compounding intrinsic value over time. He said that he wasn’t sure when or if the market would revalue the assets to a more fairly valued multiple. But he took much solace in the fact that if the stock continued to be priced at the same multiple for the next decade or so, the investment would still be satisfactory as the intrinsic value would likely double in that amount of time.

In other words, he spent around $50 to buy what he roughly estimated to be $125 of intrinsic value (or “Price to Value” ratio of 0.4—a 40 cent dollar). He felt that the market should eventually price the stock much closer to its true value, but if it didn’t, that value would likely compound from $125 to $250 in 10 years or so. He was confident in this estimation because of the predictability and the stability of both the management and the business. It was a small community bank that does the same thing day after day, year after year. So even if the market continued valuing the business at the same multiple, Buffett would not lose money, and in fact would realize moderate returns. Not bad for a downside scenario.

Another Side note: I plan to have a separate summary post to discuss more about this investment, along with a series of posts on some of Buffett’s early investments which are interesting case studies. In fact, I have some interesting case study files from Buffett, Graham, Lynch, Klarman, and others that I’ll get around to posting over time.

So the point I’m trying to make is that while it’s great to find something cheap, if you can a business that is cheap that also has the ability to compound intrinsic value over time, you significantly increase your margin of safety, not to mention the upside possibility of the investment. More simply, you put time on your side.

Growth Predictions Aren’t Necessary, But Patience Is

Keep in mind, success in investing does not require the ability to have an abnormally high ability to predict business developments or future earnings. But it does require one to think differently and maintain a long term view. The biggest edge an investor can bring to the marketplace is his or her ability to be patient and maintain a long term view.

This is a monumental advantage for individual investors—and one that is rarely taken advantage of. Most professionals don’t or can’t think long term. Personally, I’m fortunate to be able to invest with a 5-10 year plus timeframe and I’m lucky that I have a small, core group of clients who allow me to act and think in this manner. I’ve tried hard to educate them on the merits of this type of thinking, as it is imperative to the achievement of long term outperformance. My client base combined with my investment philosophy and discipline gives me my edge… not any superior ability to predict business cycles, economic outcomes, product evolution, etc… My setup allows me to wait and wait and wait and wait for the right investment. And then wait and wait and wait some more. Patience is a virtue in investing and a tailwind to long term results.

To Sum it Up

So I like both asset-based investments as well as great operating businesses with high earnings yields. I think it’s important to remember that asset/earnings revaluation (the buzz phrase used by most analysts is “multiple expansion”) alone only uses one of the three factors that create shareholder returns. Asset revaluation combined with competent cash allocation by management can create a great result—sort of a Davis Double Play for asset investments.

However, “all intelligent investing is value investing” as Munger said. The idea is that we find an investment that will result in either higher earnings over time, higher multiples over time, or higher dividends/reduced share count over time… preferably a combination of two or three of those factors.

It’s always worth repeating this simple quote from Greenblatt: “Value investing is figuring out what something is worth and paying a lot less for it”.

Thanks for the comment Pedro. Yeah, I think in the end, it all comes down to the net present value of the business we’re looking at. I like the way your broke down the categories. Basically, I would sum up all three by simply saying that the basic goal is to determine present value and compare that to price. And certainly with a business that can grow intrinsic value at a high rate over time is presently worth more than a business with stagnant or shrinking intrinsic value.

Just different ways of saying the same thing. In other words, if you pay a dollar for a dollar that next year will be a $1.20 and the year after will be $1.44, then I would liken that to a situation where I can pay $0.50 for a $1.00 that is stable but unlikely to grow, etc… In other words, a dollar that is growing at a high rate is worth more than a dollar…

Maybe I’m getting too verbose here. The idea at Base Hit Investing is simply to buy good stable businesses for less than what they are worth.

Good question… I enjoy finding situations where I can buy assets for significantly less than what they are worth. I wouldn’t say I’m necessarily a “fan” of net net investing. I’m just a fan of finding stocks that are worth 2 or 3 times what I can buy them at. I look at net nets from time to time, but I don’t typically invest in them. I find that more often than not the businesses have shrinking intrinsic values (burning cash, high liabilities, eroding market positions, etc…). There are exceptions to this general rule. Occasionally good businesses that are small and underfollowed become this cheap. But overall, most net nets are businesses that I wouldn’t really be excited about owning. This doesn’t mean that I think the strategy is a poor one, it just means that I’m more comfortable investing in businesses that are growing intrinsic value. I feel this reduces risk. By the way, this doesn’t mean I am willing to pay up for good businesses. I still want really cheap stocks, and many of the ideas I look at are filled with pessimism or temporary problems. But I prefer businesses that can compound intrinsic value over time. If I could find a net net that matched that description, I’d certainly be interested in them.

Of course, there are certain exceptions to my blanket statement above… in 2008-09 there were stocks with stable businesses that traded below NCAV, but there were also really good businesses that got cheap as well… I’m just looking for the largest gaps between price and value, wherever they might be.

I think if you diversify and own a basket of net nets, you’ll do quite well over time most likely.

I buy net net stocks exclusively and don’t screen out companies suffering losses or that have shrinking NCAV. The studies that I have looked at have shown no correlation with losses and returns. When I buy net nets with shrinking NCAV I just make sure there’s not too much erosion and demand a very steep discount to NCAV value. Even these stocks seem to work out well.

I totally agree with John — if you own a basket of them then you will do very well over time.

Thanks for the comment Evan. Yeah those studies are quite interesting. My guess is that the unprofitable net nets get beaten down even more because they are even “uglier” than the profitable net nets, and so on balance, if they turn around, they have more upside. I’ve always felt that these are riskier investments on an individual basis, but on the aggregate, like the insurance underwriting business model, they can work out. Thanks for reading!

great article! i aslo like asset based investing and focus on stocks traded below book. these stocks are often out of favor and very ugly no one want. but i don’t think so and they are my winners. value investing is contrarian investing in essence and goes against human nature.

A good post. I’m not sure why some people think growth doesn’t have value. I’m a net net stock investor and often the best net net stocks to invest in are the ones showing growth in earnings or their NCAV.

I don’t want to post links in the comments of your site, but this article here definitely backs up what you’re saying about combining a ben graham styled margin of safety with growth:

In the value vs. growth debate, it’s worth mentioning that growth performs really well in the market. I think growth is so successful in the market because the information is easy to digest for people without experience in analysis. Just look at the recent successes in the market: GMCR, NFLX, social media stocks. The best ones seem to be the ‘light’ business models with a large growth runway. The ‘growth’ factor seems to be there for the best-performing stocks over a long period of time. This got me thinking, and now I prefer a ‘light’, growing 5% FCF yield to a slow/non-growing 15% FCF yield. It’s hard not to be stubborn about growth because its value is extremely hard to model, but if you’re right about one growth stock then you’ve made a lot of money. I’m sure a lot of people passed up on MNST (formerly Hansen’s) just because it was trading at 40-50x P/E. There was even a short position write-up in ’05 on VIC based on the high multiples and assumption that Monster Energy was a ‘fad.’ MNST is up well over 1,000% since that write-up.

Great Quotes

“Invert, Always Invert.”— Carl Gustav Jacob Jacobi, 19th century mathematician, using the phrase to describe how he thought many problems in math could be solved by looking at the inverse. Charlie Munger often uses this same quote to express how investors can likewise benefit by looking at the inverse, or